Management of Asset Risk - ICM - 18

Risk & Capital Management Seminar - 9 July 2002

I N S U R A N C E A S S E T M A N A G E M E N T

2

Types of risk

• Do I have the correct strategy?– Model Risk– Strategic Allocation

• Can I implement the strategy?– Process Risk– Tactical Allocation

3

Agenda

• Definition of Risk

• Fixed Income Risk– Duration– Yield Curve– Credit/Sector– Security Selection

• Measuring and Controlling

4

What is Risk?

• Not necessarily volatility of returns

• Definitely not operational

• Ability to track benchmark

• Is this appropriate?

5

Risk Types

Risk Type Interest RatePredictability LowImpact HighEffectiveness LowInsurance Duration matching

Risk Type SectorPredictability MediumImpact MediumEffectiveness MediumInsurance No

Risk Type CreditPredictability LowImpact HighEffectiveness LowInsurance RBC, NAIC

Risk Type SecurityPredictability HighImpact MediumEffectiveness HighInsurance No

6

The Insurance Bias

Typical Insurance Account

Security Selection

Credit Risk

Yield Curve

Duration

Best Risk-Adjusted Returns - Lehman

Brothers

7

Duration

• IF asset duration = liability duration, THEN, parallel changes in yield curve will not affect surplus

• Usefulness– Liabilities not discounted - not affected by yield

curve movements– Yield curve movement not parallel– VFIC report

• Matching not necessarily better• Accounting standards matter

8

Measuring Duration

Rate

Pric

e

with option

without option

P PP- +0

9

Yield Curve Movements

• Guessing at the movement– Higher interest rates shorter duration– Lower interest rates longer duration– Steeper curve barbell – Flatter curve bullet

• Not very effective– Especially over longer horizons

• High up and downside potential

10

Credit Spreads

• U. S. Treasury Securities guaranteed by “full faith and credit” of the U.S.– No chance of default– Deep market– Caveat: yield curve movements

• All other securities contain credit risk

• Risk requires compensation

11

Credit Spreads

• Credit Spread - Difference in yield between debt and U.S. Treasury debt of same maturity

• Credit Component• Liquidity Component

Credit Spread

CreditLiquidity

Yield

CreditTreasury

12

Credit Spreads

• Liquidity component fluctuates with market– Issue age & size– Not quality

• Rating agencies guide credit component

• S&P Ratings• Investment Grade

– AAA– AA– A– BBB

• Non Investment Grade– BB– B– C– D

13

Credit Spreads

• Spreads not static– Increase = “widening”– Decrease = “tightening”

Spread Yield Price

14

Credit Spreads

Aaa Aa A Baa Ba B Caa Def

Aaa 96.5 3.5 0.0 0.0 0.0 0.0 0.0 0.0

Aa 1.8 91.3 6.9 0.0 0.0 0.0 0.0 0.0

A 0.0 2.2 91.4 5.9 0.2 0.3 0.0 0.0

Baa 0.1 0.3 4.7 88.7 5.1 1.0 0.0 0.1

Ba 0.0 0.2 0.3 8.4 78.6 10.3 1.0 1.2

B 0.0 0.0 0.3 0.4 4.5 82.0 6.6 6.2

Caa 0.0 0.0 0.0 0.0 0.0 5.5 74.0 20.5

Ratings at end of year

Ratings at beginning of

year

Source: Moody’s

15

Credit Problems

• Credit ratings not predictive– Quality is predictive

• Contradictory regulatory messages– High Yield highly correlated to Equity– RBC higher for Stock– High Yield not admitted in many states

16

Decomposing Credit Spreads

59

54

6647

9

112

111

0

50

100

150

200

250

Mtg Agency Asset-Backed AAA-Corp AA-Corp A-Corp BBB-Corp

Liquidity Prepayment Rating Change Default Excess Compensation

17

Security Selection

Excess Returns "A" Financials v. Treasuries

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

1.00 2.00 3.00 4.00 5.00 6.00 7.00-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00% %

Maturity

Excess R

eturn